In the next series of columns, we will be discussing what I call Your Personal Financial Security Formula (“P.F.S.F.”). Your P.F.S.F. is more than just a plan for the evaluation of the potential disaster areas within your estate. It is a formula that creates the defenses that will eliminate the vulnerabilities in your financial plan. An adequately prepared personal security formula should enable you to have greater security than if you had $1,000,000 or more in your savings account.
To develop your P.F.S.F., list all potential problems that would be solved if you had $1,000,000 or more in the bank. These problems are the same for almost everyone.
- Death of the breadwinner
- Disability of the breadwinner
- Illness of yourself or a family member
- Casualty losses involving your automobile, home or other personal belongings
- Potential personal or business liability suits
All these areas can be covered by some form of insurance. When discussing any form of insurance we have to differentiate between buying insurance and self-insuring. Self-insuring is when you keep cash available to cover potential losses instead of buying insurance to cover them.
Cash kept for this purpose represents a form of insurance. However, keeping cash available for this purpose still has a cost because to the value of the money is depreciating due to inflation. If you look back to my column explaining the First Financial Fallacy That Will Ruin Your Financial Future, you will see that money kept in a saving account loses money after evaluating its yield, less taxes and inflation. Therefore, you should look at this cost each year as your cost of self-insurance and allow that to help you determine when this makes sense or not. Any time you can insure yourself more cheaply by keeping cash, this is the form of insurance you should maintain in your security formula.
The eventuality of death
The first aspect of a P.F.S.F. to consider is death. Therefore, life insurance appears to be the obvious solution.
The only way I know how to find out how much life insurance you truly need is to assume that you will die tonight. If you did die, all the financial problems created by your death would be on your family’s shoulders tomorrow morning. After all my years as a financial planner, I have only been able to find four categories of economic problems that can arise by a client’s premature death that money can solve.
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These four problems are listed below:
- Estate Liquidity (covering the costs of dying);
- Survivorship Income Needs (providing an income stream to replace the deceased’s income);
- Special Obligations (such as providing for a college education fund or buying out a business partner); and,
- Liquidating Liabilities (extinguishing debt the family would have trouble servicing in the event of the death of a breadwinner).
The first problem listed above is Estate Liquidity. When you die, your estate has to be probated, and any taxes due have to be paid to the government, usually within nine months. If you use the unlimited marital deduction, neither you nor your spouse would owe any federal estate taxes on the first death. However, there are other miscellaneous expenses of dying such as funeral and last expenses, probate fees, appraisal fees, accounting costs, etc. I suggest you have a minimum of $50,000 or 6 percent of your net estate, whichever is greater, to cover these miscellaneous expenses.
The second potential need is survivorship income. If you, the breadwinner, die, your family must replace your income stream for it to survive. In order to determine how much is needed to solve this, you first need to establish how much monthly survivorship income you family will need. Then you need to actuarially determine the size of estate you need to have to resolve this. How to do this is described in greater detail in my book “Billionaire Cab Driver.”
The third potential problem area is special obligations like building an education fund to guarantee the education of your children. If you have yet to fund your children’s college educations, you may want to ensure that there are special assets to provide for these. I discussed the process of how to do this in an earlier column. Another example of a special obligation might be buying out a business partner or some other area of financial need.
Finally, the fourth area evaluates liabilities and mortgages. While you are working and earning money, you are capable of paying the monthly mortgages and/or other loans you have incurred. However, if you die and your family loses your income, the monthly debt service on these loans might create a burden, which your family could not afford.
When I worked with a client, I simply computed the need in each of the above areas as if he had just died. I then determined whether his needs were permanent or temporary so I could then decide whether he needed term or cash value insurance. After totaling up all his needs, I subtracted his net hard worth. The remainder was the amount of life insurance he needed.
In my next column we will explore the other area of your P.F.S.F.